Volatile Dynamics
In our view, the US economy has been bolstered by strong profits and a strong labor market, which have supported consumer spending. The Federal Reserve has paused its cutting cycle in response to recent stickier inflation data and policy remains restrictive. However, we believe significant economic headwinds will weigh on the economy. Huge uncertainty and massive supply disruptions from the tariff shock will likely cause companies to hold back on investment spending, in our view. Companies involved in US-China trade may reroute their supply chains or look for alternatives. We also expect tariffs to crimp housing supply as costs increase.
We will be watching corporate health very closely. Our most recent survey of Loomis Sayles’ credit analysts (our Credit Analyst Diffusion Indices, or CANDIs) indicated a positive outlook for corporate health, but noted rising input costs. The Loomis Sayles Credit Health Index (CHIN) is currently at a healthy level consistent with late cycle.
We believe profits are one of the most important indicators to watch because they drive the cycle. If declining demand or increased costs hit margins and profits turn negative, then companies are likely to start shedding labor. A rise in unemployment is a key signal for the downturn phase of the credit cycle.
A Closer Look
Credit cycle analysis involves measuring the changing factors that influence a cycle’s movement and tracking the complex interactions between credit and asset prices. We use our credit cycle framework to interpret data and shape our views on where a country, sector or issuer may be in the cycle. However, we do not interpret indicators at face value and make a conclusion. Our determinations incorporate art and nuance.[1] We keep in mind the variability of indicators since they can shift in large and small ways and undermine or bolster market sentiment and valuations.
Interpreting the Cycle
The key economic indicators in the following table tend to behave differently in each phase of the credit cycle. Currently, these indicators appear divided between expansion/late cycle and downturn, consistent with our analysis that downturn risks are elevated, particularly if profits collapse and leverage increases. At this stage of the cycle, investors tend to focus on capital preservation and moving up in quality.
The economy went through a period in late 2022 and early 2023 when the threat of downturn was also elevated. Excess consumer savings, pent-up demand and post-pandemic “revenge spending” were powerful engines of growth through the shallow profits recession of 2023. We expect the US economy to be less resilient this time, as excess savings have been depleted and consumer delinquencies are on the rise.
